Should I Get A 401k Loan Or Do An Early Withdrawal To Help Us Through Tough Times?

Times are tough in the U.S. and more people than ever are finding themselves in tough situations where they've lost a job and haven't been able to find something new. Unemployment is hovering around 10%, although true unemployment is probably much higher as some people have just stopped looking.

As people go further without finding something new, many of them are having to find new ways to get money to keep the lights on. One of those places people are looking is their retirement accounts. CNN reports that 401k hardship withdrawals and 401k loans are at the highest level in 10 years:

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Hardship withdrawals from 401(k) retirement saving plans rose to the highest level in 10 years during the second quarter, Fidelity Investments said on Friday, in the latest sign of a dismal economy.

Fidelity reported that, as of the second quarter, 2.2% of all 401(k) participants had made a hardship withdrawal at some point over the preceding 12 months. That's up from 2% in the prior year, and was the highest level in 10 years.

At the same time, the percentage of 401(k) participants that had an outstanding loan from their account rose to a record high of 22% in the second quarter. The average loan amount was $8,650 at the end of the quarter.

So more and more people are using their 401k accounts as a backup plan to be used when times are tough. But should they?

Early Withdrawals – Things To Consider

So what are some of the things that need to be considered when taking an early withdrawal from your 401k?

10% Early Withdrawal Penalty: When you take money out of your 401k before you turn 59 1/2, your withdrawals will be subject to a 10% penalty unless you meet certain withdrawal criteria. That's a pretty big chunk off the top!

State and Federal Taxes: Your early withdrawal will be subject to state and federal taxes which means that after the 10% penalty and taxes your withdrawal could be left with only about 60% of the total before you're done.

Short Circuiting Retirement Gains: When you withdraw from your retirement accounts, you'll be foregoing the gains you might have made on that money.

So when it comes down to it, if you take an early withdrawal you'll be losing up to 40% of the money right off the top due to taxes and penalties. That's a lot of money to give up!

401k Loans – Things To Consider

401k loans are being used now more than ever to pay off debt, pay bills and pay for other wants and needs.

Usually you can borrow up to 50% of your vested account balance or $50,000, whichever is less. You usually have a maximum of five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.

But there are things you need to consider.

401k Loans May Require Repayment Immediately If You Move Jobs Or Are Fired: These are uncertain times, and we never know what might happen tomorrow. What if you leave or lose your job before the loan is paid back? You will be obligated to pay it back immediately (although many plans offer a 60-90 day grace period) or suffer the fees and penalties associated with a 401k withdrawal. As mentioned above there is a 10% penalty, and federal and state taxes are taken out as well. In this situation you may be better off taking out a loan at a bank to repay the loan – and avoid those penalties.

If Your Stocks Are Down, You Can't Regain Losses: If you withdrew your money when the market was down, you won't be able to regain those losses when the market goes back up.

You Pay Interest To Yourself: One positive point about 401k loans is that you're paying interest to yourself, and not a big bank somewhere.

Conclusion

Personally I think that doing a 401k loan, or doing an early withdrawal from your account is hardly ever a good idea. I think it should only be used as a complete last resort. The downsides – including penalties, short circuiting gains and having to repay the loan immediately if you leave the job (when you can probably least afford it) are just too big.

What do you think about 401k loans? Are they ever a good idea, and would you take one out – or have you? Tell us your thoughts in the comments!

Comments

If this were an either/or I’d go for the loan. When you take a withdrawal, many administrators put a hold on new deposits for some time, 6 months isn’t uncommon.
The real wild card is the continued employment, and as you stated, the loan is due on separation.
But still, a withdrawal is irreversible, and the loan may keep the option open. Last I looked, my 401(k) loan rate was 3.5%. The payback for $10K is $182/mo for 5 years (the maximum you mention) but that same payment would take nearly 10 years at the higher 18% rate many still pay on credit cards.
A tough decision, but if there’s no other choice, it may be a good one.
Note – 401(k) assets are protected retirement accounts. If one loses their house and files for bankruptcy, the credit card debt is dismissed as well. Using a 401(k) loan to pay off the cards puts that money at risk, same or worse than taking a home equity loan (HELOC) to pay that type of debt.

I agree, loans or early withdrawals should be an absolute last resort! Especially in these tough market/job conditions – if you lose your job it’s time to pay up on that loan. You’re just putting yourself into a greater risk position than what you need to.

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